I had intended to write a short piece on bubbles for Valentines Day, but it seems it will be for St David's Day instead.
There have been some interesting articles about bubbles recently (if you follow Tim Harford, the 'Undercover Economist' in the FT you may have seen one a month ago). With the inflation shock receding, but a certain nervousness on valuations, there are many who worry that we may see a deflation of the current 'asset price bubble'. I don't know if that will happen or not. I guess we shall see some falls in illiquid assets. But asset prices can be hard to predict - if they weren't then we'd be living in a very different world.
Firstly a little bit of classification. A bubble is where many people feel a set of connected assets have risen in price quickly and without significant changes in the seeming drivers of valuation. A sort of demand driven rise in prices. They are likely separable into those bubbles driven by fraud and those which are not. Here I mean fraud quite widely - any attempt to create value by falsity or similar. But bubbles can have both characteristics - in a sense be in a mixed state between rises being helped by ramping or lies of substance, but also by members of the market buying those assets without reliance on those falsehoods (I think meme stocks and other penny stock type ramps have some of this type of character). Lastly there may be bubbles formed by mistakes - I know of a few in the model risk world; where assets have increased in value based on mistakes in valuation, created by wrongly used models. I am focusing on real bubbles - not fraud, not mistakes at work.
In essence my theory of bubbles is that mis-valuations occur because the boundary of the valuation problem is poorly drawn. It may be easier to think of an example. Railways are a good one. This was a paradigm shift in transport technology. Many people invested in railways; many railways were built; railways transformed transport and created new opportunities and new industries. Infrastructure has a good growth effect on GDP and hence wealth (as long as it is done 'right'), and hence railways created wealth and value. But investors in railways did not do well. Investors appear to have mistaken where the gains from railways are made in wealth creation. They are made by the users of railways rather than the railway.
Other examples are firstly 'Tulipomania'. Whatever happened in Holland during the mania for tulips, one thing is true: Tulips are big business in the Netherlands today. Or the tech bubble of the 2000s. Which does seem to have destroyed wealth, along with creating highly valued tech giants.
Bubbles in asset prices are often underpinned by something real - new technologies, opportunities or ideas - but the difficulty comes in deciding what will be valued by investors tomorrow. And this value is often more widely drawn than the initial bubble in certain assets suggests.
Hence when we see a bubble in asset prices, the right approach is not to ignore it, but to look for the wider opportunities and the new worlds being opened up. These may be the real opportunity, not the bubble itself. Thinking this way can help draw a distinction between bubbles and illiquid and volatile assets.
House prices seem very likely to fall. They are not a bubble. They are more illiquid and more volatile than most people think.
I have many other thoughts on the above. Both technical and practical. Get in touch if you'd like to discuss.
Lewis O'Donald
lewis.odonald@arborealriskadvisors.com
Founding Partner
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